This article assumes that you live in the U.S. See the end for the usual disclaimer.
Some countries have robust support systems that make planning for retirement simple or even wholly unnecessary. The U.S. is not one of those countries: In 2020, the average monthly Social Security benefit was only $1,503, which comes out to $18,036 per year (source).
Planning how to save for retirement is important, and it pays off in the long run, but it’s hard to know where to begin — and the more you procrastinate, the more opportunities for “free” money you miss out on.
Whether you’re 20 or 60, employed or not, you should at least know what your options are.
You could hide cash under your mattress, but cash loses purchasing power over time due to inflation (meaning that a coffee these days is more expensive than a similar coffee 10 years ago), so that’s not ideal. You could put money into a savings account at your bank, or directly into the stock market — but as you’ll see, there are better options available specifically for retirement.
What is a retirement account?
A retirement account is similar to a bank account — whether you store your money at a big national bank or a local credit union, they’re both simply bank accounts, and the money stored in them belongs to you.
Your money can be treated differently depending on whether you categorize it as “checking” or “savings” (for example, the different types of account might earn interest at different rates), but in either case, it’s still in a bank account.
Instead of choosing between checking and savings like at a bank, there are different options for retirement accounts. You could, for example, do nothing and let your money sit there uninvested just like in a checking account. Or you could choose to invest the account in something like an index fund and earn interest based on the stock market.
What are the benefits?
The main benefit of retirement accounts is that they’re tax-advantaged, meaning you get to keep more of the money you earn.
The catch is that retirement accounts have rules about how much you’re allowed to contribute per year and when you’re supposed to withdraw money. In many cases, you’ll need to wait until you’re 59 ½ years old before withdrawing untaxed money from it — otherwise you’ll be charged an additional fee on top of the regular taxes, which defeats the purpose.
When you invest your money, interest accumulates quickly. If you earn 8% interest every year, for example, your money would more than double every 10 years. At that rate, a single investment of $1,000 would grow to over $21,000 after 40 years. That’s 20x more money, all tax-free!
What are the options?
There are two most common types of retirement account:
- 401(k): Named after section
401bullet pointkof the tax code. Your employer can set these up. Often you can contribute a percentage of your paycheck automatically. - IRA: Individual Retirement Account. You can set these up yourself and make your own contributions.
You can use either type of account (or both at once), assuming you meet some standard requirements.
There are other types of retirement account, too, such as 403(b) and SIMPLE, but they’re for more specific situations and they won’t be covered in this article.
Which account do I choose?
Are you employed, and does your employer have a 401(k) plan? Then you most likely want to talk with your HR department to find out how to use it. Otherwise, you most likely want to set up an IRA for yourself — you can do it all online at Vanguard or Fidelity, for example. You’re also free to use both a 401(k) and an IRA at the same time.
The next step, regardless of whether it’s a 401(k) or an IRA, is to designate it as either a Roth account or as a Traditional account. The difference is small but important:
- Roth: You pay taxes only before depositing your investment. Interest earned is tax-free.
- Traditional: You pay taxes only after withdrawing the money in retirement, so the amount contributed each year reduces your current taxes.
Example — Contributing
Say you make $50,000 per year and you pay a flat 20% in taxes.
If you want to contribute to a Roth account, you’ll pay that 20% tax first, before contributing. If you want to contribute to a Traditional account, you’ll contribute first, then pay taxes on what’s left of your income. Let’s say you want to contribute $5,000 this year:
Roth
$50,000 income − 20% income tax = $40,000 in pocket
Then:
$40,000 in pocket − $5,000 Roth contribution = $35,000 in pocket
Traditional
$50,000 income − $5,000 Traditional contribution = $45,000 income
Then:
$45,000 income − 20% income tax = $36,000 in pocket
So far, you keep $1,000 more by choosing a Traditional account.
Example — Withdrawing
Say it’s 10 years later, you’re retiring, and you’ve doubled your money — earning $5,000 in interest on your initial $5,000 contribution. Assume your tax rate now is still a flat 20%:
Roth
$5,000 contribution + $5,000 interest − $0 tax = $10,000 withdrawal
Traditional
$5,000 contribution + $5,000 interest − 20% tax = $8,000 withdrawal
Now you withdraw $2,000 more by choosing a Roth account.
Which type do I choose?
As with everything in life, it depends. If you think your tax rate in retirement will be much different than it is now, that changes things. The example above assumes the rate doesn’t change. You also aren’t allowed to use a Roth if you make over a certain (large) amount of money in a year.
With a Roth account, in this example, you keep $1,000 less right now ($35,000 compared to $36,000) but you keep $2,000 more in retirement ($10,000 compared to $8,000). It’s more money total with the Roth, but you sacrifice some spending power now in order to get more in the future.
If you were tricky, you might decide to use a Traditional account and also invest that extra $1,000 right now in a non-retirement account. It might double over 10 years the same as your $5,000 did, but that extra investment would not be tax-advantaged, so you’d only end up keeping $1,800 (after paying 20% in taxes on the $1,000 in interest) instead of the $2,000 you’d have kept by choosing a Roth.
Again, these are all just hypothetical examples. Try running through the numbers again using your own estimates — there are easy calculators online to help with this.
When do I start?
There are several reasons why you might want to contribute sooner rather than later.
First, because interest compounds, you’ll earn a lot more interest if you start now than if you start in 20 years. If you contribute $5,000 per year to retirement and earn 8% interest, in 40 years you’ll have $1.4 million in your retirement account. If you instead wait 20 years and then try to catch up by contributing twice as much ($10,000 per year) for the 20 remaining years, you’ll contribute the same total amount (40 x $5k = 20 x $10k = $200,000) but will only end up with $470,000 in your retirement account due to earning $0 interest for the first 20 years. You’ll lose out on nearly $1 million, retiring with around a third as much as you would have by saving early.
Second, there’s a limit to how much you can contribute to each type of retirement account each year. The limit changes every year, but for example, you might be allowed to contribute $5,000 max to IRAs and $20,000 max to 401(k)s in a given year. That means you can contribute $25,000 total this year, and if you wait until next year, you’ll have missed the opportunity to save more on your taxes. This mostly matters to people who earn enough income that they can contribute close to the maximum every year.
Finally, some companies offer contribution matching, which means they pay you extra just for contributing to your own retirement. And the match amount doesn’t count toward your yearly limit, so you can contribute even more total.
What about debt?
Saving for retirement right now isn’t necessarily the right choice for everyone. Sometimes it’s better to pay off your high-interest loans first such as credit card debt, or to save for emergencies, help friends afford groceries, etc. There’s a fantastic summary on Reddit if you want to learn more about personal finance and what next steps you could take in your own situation.
Worth repeating: check out this guide!
Finally, if you found this useful, please help by tapping the 👏 button as many times as you’d like so others can find it too. And if you have any suggestions or corrections, please post them in the comments so we can all learn.
Disclaimer: This is a simplified explanation, and is not meant to be legal or financial advice. Find a licensed professional to consider your individual situation.
